Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

COVID-19, markets, and ESG: what we’ve learnt so far

The relative performance of stocks with stronger environmental, social, and governance (ESG) attributes suggests responsible investment strategies may not be just a bull market phenomenon but also a bear market backstop.

 

ESG integration, which has consumed asset managers and owners alike in recent years, remains contentious. For some, it is still a ‘nice to have’ rather than a ‘need to have’.

We believe that ESG factors are financially material. As a result, responsible investing is in our view essential for mitigating risks, unearthing investment opportunities, and strengthening long-term returns.

However, ESG sceptics have previously deployed a valid argument against this stance: that responsible investment strategies had yet to be tested in both up and down markets, particularly during periods of prolonged market volatility.

These past few weeks of market turbulence, triggered by the coronavirus pandemic, have provided that test. While these are still very early days, and past performance certainly remains no guide to the future, the indications are positive.

Searching for a safe haven

A flurry of sell-side analyst reports have suggested that stocks ranking highly against ESG metrics have outperformed those that rank poorly during both the market selloff in the fourth quarter of 2018 and the most recent drawdown. Likewise, investment funds that make decisions based at least partly on ESG criteria have outperformed equivalent strategies over the same period, according to data from Morningstar.[1] There were few places to hide in March, but such strategies presented something of a safe haven on a relative basis.

Indeed, according to research from Bank of America, since the S&P 500 index’s peak in February, stocks in the top quintile by ESG outperformed the market by over 5%. Even adjusting for size and sector performance (specifically small-caps and energy), highly ranked ESG stocks outperformed the S&P 500 by 3-4%, and the S&P 500 stocks most held by ESG funds have meaningfully outperformed those typically underweighted by ESG funds during the most recent selloff.

In Europe, ESG indices have similarly outperformed their equivalent benchmarks year to date. The 50 most overweight stocks in ESG funds have outperformed the most underweight by more than 10% through that time, especially during the selloff, Bank of America has also reported.

Given the climate emergency, the E in ESG has tended to be the most emphasised of the letters in recent years, but the S has risen to greater prominence over the past few weeks. Bank of America has duly found that companies demonstrating a good track record in areas such as employment rights and flexible workforce policies (for example, around childcare) have driven stock dispersion more than environmental or governance factors through the correction.

Furthermore, although we are still at the early stages of understanding the full extent of the COVID-19 crisis, companies across the US, Europe, and the Asia Pacific region with below-median ESG scores have seen larger downward revisions to their earnings per share this year, and vice versa, according to Bank of America.

Reaping the rewards

Research from Morningstar and S&P Global Market Intelligence has also found that across 17 ESG exchange-traded and mutual funds, 12 had lost less value than the S&P 500 index from the start of the year to 9 April.[2]

It is important to acknowledge that some of the outperformance can be attributed to ESG funds having reduced exposure to sectors such as energy, which have been hardest hit during the crisis. However, the pandemic has also shone a light on other ESG characteristics that were not previously seen as necessary contributors to performance, such as labour practices and employee health and safety.

Investors appear to be voting with their feet. According to data on fund flows from Bank of America, ESG funds globally registered inflows in the 10 weeks to 14 April. Even after the market selloff, ESG exchange-traded fund (ETF) assets under management are still up by nearly 5% year to date, while S&P 500 ETFs have seen a decline of over 30% in assets.

ESG is here to stay

The early identification of potential risks that threaten the sustainability of returns is central to our investment philosophy.

In spite of the recent performance cited above, we still do not believe the pricing mechanism in markets is discounting all ESG-related risks correctly – particularly those stemming from climate change – as investors lack the information necessary to do so.

This helps explain why asset owners remain under increasing pressure from regulators to demonstrate the integration of ESG considerations through product and manager selection, as well as the assessment of risks posed by climate change.

ESG integration means that every investment decision taken is reached and challenged through this additional lens of scrutiny. We believe 360-degree ESG assessments will be crucial in determining which companies and industries are likely to survive both this crisis and future challenges, and those that simply will not.

We are also of the view that, as Shaunak and Caroline have written, investors can play a real role in building a world that is more resilient to future crises like pandemics by allocating capital to ESG leaders.

The financial-market rulebook has been torn up and rewritten in recent weeks, but one thing is clear – ESG is here to stay.

 

To read our annual report on our stewardship activities and how we integrate ESG considerations, please click here.

 

[1] https://www.ft.com/content/46bb05a9-23b2-4958-888a-c3e614d75199

[2] All the funds were domiciled in Europe and state in their prospectus that they use ESG criteria as a key part of their security-selection process, or indicate that they pursue a sustainability-related theme or seek a measurable positive impact alongside financial return.

 

Key Risks

Past performance is not a guide to the future. The value of an investment and any income taken from it is not guaranteed and can go down as well as up; you may not get back the amount you originally invested.

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